Kostantin Fisun of Concorde Capital -

The recent election of a new legislative body gives reason to pause and reflect. In the three years since the presidential election of 2004, the Ukrainian political climate has been anything but calm. The revamping of the political system during the course of the Orange Revolution, the breakdown of the winners' coalition, revanche of the opposition, dissolution of parliament and snap elections - it has been quite a bumpy road.

Nevertheless, investors quickly adapted to the "peaceful" nature of politics a la Ukraine. From October 2004 to October 2007, the PFTS index posted growth of some 700% (ie. nearly doubling every 12 months on average). In just the first nine months of this year, the PFTS made 107%, despite two substantial corrections in spring and summer. It would take a while to find something comparable in another emerging market. All these extraordinary returns have come with a decreasing risk profile: the volatility of the Ukrainian market over this three-year span is on par with Russia, China and India, less than Brazil, Turkey or Vietnam. The risk-free rate proxy, as gauged by Ukrainian sovereign Eurobond yields, shed 100-150 basis points over the period.

What becomes clear after deploying some algebra is that Ukraine as an asset class in a global context is a powerful diversification tool. For example, keeping within a BRIC investment paradigm, exposure to Ukrainian equities helps to noticeably extend the efficient frontier. With a 0.11-0.17 correlation to individual markets, the addition of Ukraine boosts returns of any BRIC portfolio while allowing for reduced volatility.

Low liquidity, in the past the major impediment for larger funds in implementing this tactic, has been improving notably. For the last couple of years, monthly volumes on the PFTS have been exceeding annual numbers before 2004. By the way, the PFTS only represents a 10-15% tip of the real over-the-counter trading iceberg, which is mostly in depositary receipts. Trading is increasingly drifting to Frankfurt and London - much more convenient locales for global funds - new equity placements are structured as share offerings in offshore holding companies, with listings on international stock exchanges. Packed either as private placements or IPOs, they have become an important supplier of fresh free float to the marketplace. After an insignificant 2004, the market received some $250m in 2005, $365m in 2006, and over $1bn already in the first nine months of 2007. The largest placement to date was the $420m IPO of Ferrexpo in London in June. Large Ukrainian business groups (like SCM and Interpipe) are in the process of structuring their assets with a view to billion-dollar IPOs in London. Overall, since 2004, new supply and appreciation increased the free float of Ukrainian stocks by more than $4bn.

Well, with improving liquidity and lower risks, how much appreciation potential remains? The answer is: still a lot, at least for the next couple years due to exposure to sectors in their early growth stages.

In real estate (free float of about $900m), spurred by the rising economy, there is now a huge deficit of quality properties. After some 30% growth of modern office space in Ukrainian capital since 2005, 215 square meter (sqm) per 1,000 inhabitants is still no more than 20% of the CEE average. Retail space in Kyiv (117 sqm per 1,000 inhabitants) is five times smaller than in neighboring Warsaw. Ukraine's per capita residential stock of 23 sqm remains about half of the European average. Banking assets grew at a respectful 53% compound average growth rate (CAGR) over 2004-2006, 73% in the first half of this year ($700m free float is available on the market). Retail turnover enjoyed a CAGR of 22.7% over 2004-2006, with another 26.1% in the first half of this year (free float in this segment remains insufficient, but equity placements are pending). The food sector, insurance, and agriculture are next on the maturity curve. With still a lot room ahead to catch up to other markets, Ukraine will probably remain less correlated to global markets for an extended period.

Last but not least, the reliability of market data, an essential part of any investor's toolbox, is finally improving as Ukrainian equities gain more visibility. The PFTS index basket has been extended from 10 stocks three years ago to 18 today, the Vienna stock exchange launched a Ukrainian Traded Index (UTX) in September, and on September 24, Ferrexpo became the first Ukrainian stock included into the FTSE-250. Even more importantly, MSCI-Barra is preparing to launch an MSCI Frontier Markets Ukraine Index in the coming months. In addition to the single-country index, Ukraine will be included into at least five Frontier Markets Composite Indices.

Putting it all together, the ability of Ukrainian financial markets to march to a different beat than politics, persistently high expected returns, easing of perceived risks and no fundamental reasons in the mid-term for a sharp increase in correlation to global markets - all these are proper building blocks for the Ukraine's prospects as an important element of global portfolio strategies.

Kostantin Fisun is Head of Research at Concorde Capital in Kyiv

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